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CRS — China’s Holdings of U.S. Securities: Implications for the U.S. Economy

Source: Congressional Research Service (via Federation of American Scientists)

Given its relatively low savings rate, the U.S. economy depends heavily on foreign capital inflows from countries with high savings rates (such as China) to meet its domestic investment needs and to fund the federal budget deficit. The willingness of foreigners to invest in the U.S. economy and purchase U.S. public debt has helped keep U.S. real interest rates low. However, many economists contend that U.S. dependency on foreign savings exposes the U.S. economy to certain risks, and some argue that such dependency was a contributing factor to the U.S. housing bubble and subsequent global financial crisis that began in 2008.

China’s policy of intervening in currency markets to limit the appreciation of its currency against the dollar (and other currencies) has made it the world’s largest and fastest growing holder of foreign exchange reserves, especially U.S. dollars. China has invested a large share of these reserves in U.S. private and public securities, which include long-term (LT) Treasury debt, LT U.S. agency debt, LT U.S. corporate debt, LT U.S. equities, and short-term debt. As of June 2011, China was the largest holder of U.S. securities, which totaled $1.73 trillion. U.S. Treasury securities constitute the largest category of China’s holdings of U.S. securities—these totaled $1.16 trillion as of September 2012, but were down from their peak of $1.31 trillion in July 2011.

China’s large holdings of U.S. securities have raised a number of concerns in both China and the United States. For example, in 2009, Chinese Premier Wen Jiabao stated that he was “a little worried” about the “safety” of China’s holdings of U.S. debt. The sharp debate in Congress over raising the public debt ceiling in the summer of 2011 and the subsequent downgrade of the U.S. long-term sovereign credit from AAA to AA + by Standard and Poor’s in August 2011 appears to have intensified Chinese concerns. In addition, Chinese officials have criticized U.S. fiscal monetary policies, such as quantitative easing by the U.S. Federal Reserve, arguing that they could lead to higher U.S. inflation and/or a significant weakening of the dollar, which could reduce the value of China’s U.S. debt holdings in the future. Some Chinese analysts have urged the government to diversify its reserves away from U.S. dollar assets, while others have called for more rapid appreciation of China’s currency, which could lessen the need to hold U.S. assets.

Many U.S. policymakers have expressed concern over the size of China’s holdings of U.S. government debt. For example, some contend that China might decide to sell a large share of its U.S. securities holdings, which could induce other foreign investors to sell off their U.S. holdings as well, which in turn could destabilize the U.S. economy. Others argue that China could use its large holdings of U.S. debt as a bargaining chip in its dealing with the United States on economic and non-economic issues. In the 112th Congress, H.R. 2166 and S. 1028 would seek to increase the transparency of foreign ownership of U.S. debt instruments, especially China’s, in order to assess if such holdings posed potential risks for the United States. The conference report accompanying the National Defense Authorization Act of FY2012 (H.R. 1540, P.L. 112-81) included a provision requiring the Secretary of Defense to conduct a national security risk assessment of U.S. federal debt held by China. Many analysts argue that China’s holdings of U.S. debt give it little leverage over the United States because as long as China continues to hold down the value of its currency to the U.S. dollar, it will have few options other than to keep investing in U.S. dollar assets. A Chinese attempt to sell a large portion of its dollar holdings could reduce the value of its remaining dollar holdings, and any subsequent negative shocks to the U.S. (and global) economy could dampen U.S. demand for Chinese exports. They contend that the main issue for U.S. policymakers is not China’s large holdings of U.S. securities per se, but rather the high U.S. reliance on foreign capital in general, and whether such borrowing is sustainable.